How to start investing in stocks: A comprehensive guide

Karl Ahlstedt
21/04/2018 00:00

This guide will look at the strategies accessible to new investors, and how to apply it in a way that makes sense for you.

From Reddit to Quora. I have seen first hand the common mistakes new investors make when buying shares (or any other asset) for the first time. I have seen how good advice from sophisticated investors can be taken out of context and lead to the newbie making bad, and sometimes very costly investment decisions. Todays post will provide not just a few lines on industry standards, it will show you exactly how to start investing in the stocks and shares markets using common city trader practices.

This includes:

Step 1: Saving & Initial Investment

Step 2: Plan & Portfolio

Step 3: Practice with Pen & Paper

Step 4: Executing Trades

Saving & Initial Investment: Step 1

There’s often a lot to consider when trying to build an investment pot. Living expenditures form the bulk of this: needs and wants. The trick here is reducing the spend on wants and focusing on the needs. Rent, food, fuel, clothing and all the needs should be prioritised.

Make a list of the expenditure of all the needs and then what’s left can be spent on the wants, one of which in this case is investing.

This should form the bulk of your disposable income, and the best piece of advice I can give is to be consistent – decide what you can afford to investment each month and stick to it. The cumulative benefits of doing this will be a catalyst for your investments growth in value, and that can be a real morale booster for new investors. To learn more about the effects of consistency see Compounding: Why it Matters.

Ways to Start Saving:

Automatic Bank Transfers

It is possible to set up an automatic transfer of money from one account into another each month. To do this you will need bank accounts, and to set up a transfer (perhaps the day after your paycheque) to move an amount into what will become your investment capital. This can be as little or as much as you can afford, and the key is consistency. Having it automated and away from your main current account should help keep you on track!

Money Pots

Dividing your expenditures into different pots can give you a comprehensive idea of what and how much money you spend monthly. This visual approach is often very effective and is a good money management technique. It lends itself well to consistency, as once set-up the process is quick and convenient which helps develop the actions into a habit.

Loose change

It might not lend itself towards consistency as well as the other entries on this list but cleaning out all the loose change at the back of sofas can often provide a surprising amount of change for the money pot.

Lifestyle Changes

This entry depends on your own daily life and activities. If you use the gym, could you instead take up jogging and running at local parks? Spending money on Starbucks? Why not make your own coffee in the morning?

The list could go on but reducing frivolous and often expensive luxuries could help you achieve the goal of financial independence and a growing investment pot much sooner than you might think.

Extra Hours

Unlikely to be the favourite option, but working more hours is one sure-fire way to building an investment fund quickly. This might be incorporated as an extra 2 hours a day, which can eventually turn into a significant amount of capital.

Plan & Portfolio: Step 2

Now that you have capital put aside ready to invest, it is time to start thinking about the process that can be used to invest.

One of the most often asked questions is: “How do I know which company to pick?”

An innocent question on the face of it, but the technicalities do not have a single simple answer. The answer is always very much “it depends”. As a word of caution, investing in shares is not easy – and so many people are looking for easy solutions. This compasses people who ask 1. “which company do you recommend I invest in” and 2. “Will a <insert fancy AI name here> make me money?”.

Lets address these two individually:

First off I would never recommend to make a trade based on someone else's recommendation. If it goes well you won't know when to sell, and if it goes badly that's usually followed by panic, as you have no idea why the stock is falling, and usually you'll close out at the worst possible time. The world is also to full of people wanting "tips" because that's easy, but consistently making money is the financial markets is not easy, it's often time consuming and hard.

There are algorithm-based programmes out there that do make money, that’s a fact. Unfortunately, the ones that work are guarded about as closely as a military installation – the largest investment banks and hedge funds profit to the tune of billions each year because of them. This means they are unlikely to share it around or offer it for $99 a month (Read, its almost always a scam).

The real answer to “How do I know which company to pick” starts with idea generation. Honest and hopefully original idea generation generated by you – and not just a rehash of the latest headline.

The very first step to buying shares happens a long time before we press execute, and purchase shares of a company. This first step is idea generation, where we come up with a view, an opinion on the world that we can then use to generate a trading idea. The best traders are often the ones with insight into the world around us, and those who can disseminate the changes happening in different areas. From culture to politics and religion, where there is change there is an opportunity to digest that change to form a view or opinion on the direction of the change.

The world we live in is dynamic and vast, and the financial markets seek to facilitate the purchase and sale of assets. From coffee and its many derivatives to currency in the forex markets. The high number of markets and exchanges provides us with a diverse range of opportunities to make money.

Soft Idea Indicators:

The essence of this theory is concerned with holding a view that is the opposite to the view held by the majority. Human behaviour has shown us that we follow the consensus opinion, in theories such as herd mentality. This often results in us making decisions because of the influence of our peers.

This is a deeply flawed approach to investing. It is usually more profitable to invest in ideas that few people have noticed. This can be easily explained by using an example.

If the consensus or majority opinion is that Apple is a great stock that will go up, then the demand for Apple shares will be very high, which results in an increased share price which can make the stock very expensive. This is usually measured in what is known as the PE ratio, which is covered later.

Finding great ideas that are not the consensus opinion can be difficult, and it would not be unwise to hold shares in very large companies such as Apple. However, it is important to distinguish that making any investment due to the opinion of the majority without additional indicators is extremely unwise.

Bottom up analysis:

This is where you start looking at one specific company and its exact business.

The first questions I often ask myself when thinking about bottom up analysis is what products does the company make and who do they sell that product to? Is it a new company with growth potential or an old one with steady earnings? Benchmark analysis can provide insight into how its performing relevant to its competitors, examples of benchmark analysis can be as simple as profitability, debt and liquidity ratios covered in general accounting classes.

Almost every situation you face as a consumer, to where you buy your groceries to what bank you use can all be ideas from which you can start further analysis.

Top down analysis:

This type of analysis takes the opposite approach, looking at themes or macro economics

This is all about finding interesting themes and researching them, and then figuring out which companies are likely to benefit from that theme in the near future. For example, if you think the pound is going to weaken, then this will benefit UK exporters who earn more foreign profits, which is then turned back into more pounds. Knowing this you could look at the FTSE100 and find companies such as BP whom make most of their earnings abroad. The share price of BP after Brexit rose by over 25% due to the sharp drop in the value of the pound.

To conclude, I would note the importance of recognising any potential biases you might have, and that an objective, logical approach is needed that can be supported by data, which we will cover during fundamental and technical analysis.

Step 3: Fundamental Analysis

Analysis is performed on companies by looking at the information that is made public. For all major listed companies, this will always include a balance sheet, income statement and cashflow statement. We will briefly talk about these 3 statements from the perspective of a potential investor.

Balance Sheet:

The balance sheet is always a static snap shot of the company at a particular point in time. On the left column of the balance sheet are entries of what a company “owns”, known as assets and on the right column what the company “owes” which we call liabilities.

The first thing to understand is that we can quickly value a company balance sheet by calculating the total assets, and the total liabilities and using the difference to produce what is known as the “net book value”. Professional traders use the book value, or derivatives of the book value a lot when doing fundamental analysis on a company. Book value is a very important value.

When considering the balance sheet, it is equally important to consider the “Others” entry. This entry is where company accounts will potentially hide the less flattering financials of the company they would rather investors not see. Taking the time to research what this field represents is usually worth the time to do so.

Finally, remember that the balance sheet does not take into account pension liabilities a company may have. Large listed companies can employ vast amounts of people, and so the pension liabilities have the potential to be massive long-term commitments. It is very important to find out how much a large company owns to its pension holders before making an investment.

Income Statement:

It reports financial performance over a period of time e.g. one year. The statement shows a company’s income and expenses for the reporting period and summaries financial performance. It is the statement of profit or loss that reports a profit or loss for the reporting period.

Cashflow Statement:

It presents the cash inflows and outflows of a company over a reporting period. Cash inflows and outflows are classified by operating activities, investing activities and financing activities. Operating activities include day to day transactions of the company such as sale of goods and payments to suppliers. Investing activities include the acquisition and disposal of long-term assets and other investments not included in cash equivalent. Financing activities are activities that result in changes in size and composition of the contributed equity e.g. issuing shares. Learn more here.

Summary:

Fundamental analysis is a heavily nuanced and complex subject, and every trader does it differently. Generally, it’s good to compare one company’s data to another and overtime experience and intuition will help you digest and understand the financials of a particular company.

At this stage it should be possible to generate trading ideas and to identify the companies main financial statements.

Practice with Pen & Paper: Step 3

It is now time to start testing your ideas, and this should not be done with real capital at this point. We would recommend using Google Finance to create a portfolio based on the ideas generated and the fundamental analysis performed. Execute on those ideas with a similar amount of capital as you have built up and monitor the performance over time. Once you are comfortable in your ability to generate ideas, and to perform solid fundamental analysis on those ideas to come up with trades, then it’s a case of continuing to learn and being absolutely sure that you understand the basics by the time it comes to placing your first trade with you own hard earned savings.

As a general piece of advice, the next step would be to learn more about Technical Analysis so that timing of trades could be improved.

There is always more to talk about when it comes to investing in shares, so much so that we published a book on the subject available here.